Regulators are too “backward-looking” with their attempts to reduce risk in OTC derivatives and are failing to identify where the next financial crisis is coming from, according to Larry McDonald, head of global strategy at Newedge.
While the Dodd-Frank Act, European market infrastructure regulation (EMIR) and other legislation stemming from the Group of 20 agreement on derivatives markets have made significant strides in increasing risk transparency, they are failing to anticipate the source of future crises, McDonald believes.
“Capitalism does not work without transparency of risk,” he said, “we’ve come a long way and there’s a lot more transparency of risk in the Western world, but financial crises tend to metamorphose and re-emerge in a different form years later.”
“If we look at China, we have a situation there where the risks the banks have taken there are far less visible and there are huge leverage risks in the Chinese economy today that we can’t see.”
Additionally, other areas of OTC derivatives and ongoing product developments on Wall Street have the potential to side-step regulations intended to increase transparency, and may present a risk of another financial crisis in the future.
McDonald highlights bond markets as an area that has the potential to pose significant risk to the financial system in the future.
He explains: “Participation in the corporate bond market is up several hundred percent in the last 10 years but the balance sheet of Wall Street is down some 80%. The bond crisis earlier this year from 22 May to 24 June gave us a sign of the problem, with some ETFs suffering huge liquidity problems.”
The huge variety of different OTC derivatives products means that large parts of the market are still not visible in terms of credit default swap (CDS) risk and this too could pose a problem.
McDonald is also concerned that Wall Street could in the future develop new derivatives products that are way outside the scope of what regulators are currently looking at, with the potential to introduce huge hidden risk into the market.
With regulators struggling to get to grips with the market, he called on regulators to reduce their talent differential.
“If we look at Wall Street salaries compared to regulators’ salaries there is a huge gap and regulation will never keep up the pace without closing this gap to attract top talent to work on securing the market place.”